Wednesday, May 28, 2008

This article was written by Martin Rojko, a real estate analyst and frequent guest writer at Capitalism & Freedom.

According to indicators used for measuring a housing price bubble, residential property values were inflated last year in many european countries. Morgan Stanley´s and Global Property Guide´s data indicate, that market distortion is in Spain, Ireland, Baltic states, Netherlands, Denmark, Czech republic, Great Britain. As these data were gathered in 2006, it´s more than probable more markets join now a bubbled group including Slovakia.

According to TREND calculations the price of mostly selling apartment (one-bedroom, 60 m2 livable area) were equaled to eight-year disposable household income in Bratislava area. Although numbers (not only) such these should be counted carefully, sticking out income and price is a matter of fact. Also another indicator of rental property yields signals the bubble. While a few years ago an owner in Bratislava could make 10% or more from an apartment, now it is approximately 5% (less than mortgage interest in banks). It is the result of doubling apartment prices and stabilising rents.

A long history of western developed markets suggests a normal yield of around 10 – 12%. Property gets cheap when yields approach 15 – 20%. Numbers lower than 6-8% mean overvaluation. According to ECB note house prices in euro zone are overvalued by 15 to 25% by this indicator from their historical averages.

The second indicator, price-to-income ratio, tells how many years of pretax annual earnings are necessary for a household to purchase a house. The historical rule of thumb is that one annual income indicates undervalued properties, two and three annual incomes normal valuation, and four and more annual incomes overvaluation and bubble territory.

This situation has clear solution. To bring the ratio of prices to rents and incomes back to fair value, both must rise sharply or prices must fall. Housing prices now fall in Ireland, Latvia, Estonia, Spain and Great Britain.

We can often hear some experts said that european countries haven´t so crazy lending standards as in the USA and that´s why there´s no danger to afraid of a bubble. It´s a clear misunderstanding. Subprime mortgages don´t create a bubble although it can boost it. Look at Great Britain, Ireland or Spain. There haven´t been much relaxed bank´s lending conditions (especially comparing to the USA), so why the current turmoil? Because home prices are not justified by fundamentals – income, and rents. The bubble is reality.

Now the question stands whether it will burst and harm the whole economy or slowly blowing-out. Considering three mentioned countries I see the greatest danger in Spain. First, there is a huge home supply at prices which people simply can´t afford to pay. Currently cca 650 000 unsold units. Developers will be forced to decrease price maybe 30% down to sell them. But in the meantime many firms get to financial problems and go bankrupt. Second, Spain has the highest construction sector share on GDP in Europe (nearly 18 %). When developer, building firms have troubles, banks and whole economy have also. Of course, government interferes and pumps subsidy package to the economy, but this step only postpones clearing of the market.

There´s another (empirical) point we must be aware of. It is a tight correlation between US and euro area housing prices. The latter following the former with a lag of about two years. US started to decline in 2006, so maybe this year eurozone is in order.

But what about emerging euro countries? Well, as mentioned above the bubble exists in many of them. One thing is clear. Prices are rising slower than in previous years, in some markets (Estonia) they are heading downward with mild heavy impact on a part of mortgaged buyers. They have stabilized in polish Warsaw (been for 9 months cca on the same level) and start to stabilize in Bratislava. While up to day growth was driven in most part by foreign investors, they are now (also due to so called “mortgage crisis”) away. Developers thus hope domestic buyers will continue, but prices are too high for middle classed society (as largest pool of potential clients), because they are set-up still for wealthy and investors.

Now the question is whether incomes will rise so quickly that homes will sell at this level or prices should go down. I think second alternative is the most probable (and not because of I´m not living in my own). And the sooner sellers realize this, the lesser will be impact of bursting bubble in later times. The opposite side of a coin is firms are misguided by monetary policy of central banks, which manipulate interest rate according to their needs, while a real value of the money (or better said the means of payment) can be much higher (see US). And another question here arises (when not talking of abolition), whether one central bank for many differently phased markets is the best way to cope with problems.

Monday, May 26, 2008

Gary Becker (link) and The Economist (link) recently discussed the surge in commodity prices and inflation that has driven inflation rates in emerging markets as well as in high-income economies to historic highs. For example, China's official rate of consumer price inflation is at 12-year high of 8,5 percent. Unofficial estimates have shown that Argentina's inflation rate has peaked 23 percent in 2008. Also, inflation rate in Russia has trimmed up to 14,5 percent, up from 8 percent annually. Central banks in emerging markets have repeatedly faced significant inflationary pressures. In world market, the price of oil barrel has climbed over $120 USD which gave speculators a boost in inflating the expectations that the world price of oil barrel will reach $200 percent and more.

Using the data and some basic tools of economic analysis, it is easily shown that the real price of oil per barrel in relative terms, cannot reach $200 USD unless terrorists attack or a sudden attack on oil fields in the Middle East impairs production abilities of oil producers in that part of the world. Commodity market analysts repeatedly analyze the spillover effects of the regulation of production in oil-exporting economies that generates upward changes in the world price of oil. One reason is that OPEC is a cartel of countries whose profit-making point rests on the real assumption that price elasticity of oil demand is very low which means that there's an inelastic demand for oil. In that case, producers choose to allocate relatively scarce resources by rationing the production of oil and thus increasing the price of oil which, in real conditions of imperfect competition, yields oil producers gains since inelastic consumer demand and quantity control of the production return higher profits when the price per unit of oil is increased. One of the classical solutions to avoid higher price increases and mark-ups is to shift towards the consumption of green energy that will make the demand for commodities, such as oil, more elastic and that would immediately eliminate the monopoly power of OPEC. But the shifts towards "greener energy" is a time-taking process that involves significant consumer expenditures as the price of products that are not linked to oil as production ingredient, is high. That is because, developing "green" products demands huge company expenditures in R&D, supply chains and knowledge-intensive services. Over time, the dependency on oil is expected to decline which implies that cartel stability of OPEC which controls the quantity and price of oil in the world market will decline gradually.

Among economic analysts, the surge in commodity prices is assumed as the engine of current inflationary pressures. But world supply and demand cannot solely explain the surge in commodity product prices. Impeding price controls and export subsidies have vastly contributed to a recent surge in commodity prices. Using price controls causes disparities in quantitiy demanded and supplied which leads to quantity shortages and price accomodation in underground markets. Also, various export bans, subsidies and price controls cause significant micro-inefficiencies that raise the rigidity and potentially reduce the elasticity of demand and supply.

Another important aspect of the surge in inflation in emerging markets is macroeconomic policy pursued by central banks and fiscal policymakers. For example, China responded to inflation surge by putting up more price controls and export bans. India has suspended futures trading in particular commodity markets. In the short run, such measures can cap the official inflation but in the long run, such measures do not lead to price adjustment after the endogenous and/or exogenous shocks tranquil. One of the reasons for an obviously higher inflation rate is that households in emerging markets have higher food expenditure from their budgets which places a heavy weight on food demand, making it more inelastic. Another reason is that central banks in emerging markets such as Russia, China, India and Brasil, pursued an expansionary monetary policy in recent years. Money supply, for example, has grown tremendously. In Russia, for instance, money supply has grown by a swelling 42 percent and central bank's target interest rate (6,5 percent) is far below the official inflation rate (15 percent).

On the offset, rigid labor markets and inflexible wage determination lead to price-wage spiral. An evidence has been observed in Russia where wages are growing 30 percent annually, more than 3 times more than the growth of productivity. A combination of rigid and inflexible market mechanism and expansionary macroeconomic policy as well as supply shocks contributed to the rise in the inflation rate. Even though sound growth forecast, predict a fairly stable output growth rate in the medium term, central banks in emerging markets will have to face the fact that expansionary fiscal policy must be neutralized by a rise in the interest rates and a decrease in the growth of money supply as a neccessary measure to bring the inflation under control. Continued rapid growth in emerging markets means that relative-price shock will be temporary and the food prices will remain high. Also, exchange rate flexibility is needed to avoid intended currency depreciation which sets an important pressure on inflation expectations. Thus, without tighter monetary policy and flexibile labor markets, central banks may soon repeat the mistakes which caused the great inflation in 1970s.

Monday, May 19, 2008

Here (link) is an interesting story from The Economist which discusses huge price disparities between French and German retailers. For example, a basket of almost identical durable goods costs 30 percent more in France than in Germany.

The article reports that in many places in France there are local retail monopolies protected against domestic and foreign competition. There is also no free negotiation with suppliers, the sale of non-prescription drugs is prohibited, and the consumers do not support the new law that would deregulate the retail market to liberalize entry conditions and enforce competitive mechanism.

There is a well-known fact from microeconomic theory that consumer demand curve for monopoly firm equals average revenue of the monopoly firm and that monopoly firm will never like rigid or completely elastic demand but the elasticity of demand that will be equal to 1, given the point of the maximum profit taken by the monopoly firm. Hence, the price charged by the monopolist is P = MC/1+(1/Ex,px) which means that greater monopoly power leads to higher mark-ups. And also, the allocative inefficiency of the monopoly means that firm will set the price at the point where marginal revenue and marginal cost are crossed. Hence, higher prices and quantity regulation maximize the profit of the monopoly firm but consumers face a significant welfare loss.

In France, however, only 42 percent of the respondents favored more competitive retail market while 85 percent favored sales tax cuts and 72 percent prefered the rise in the minimum wage. Competitive market is always the only way to break the rigidity and monopoly position of the firm inparticular markets. For example, if there would be sales tax cut, that would not change the structure of the market but it would have an effect on the price elasticity of demand and since a local monopoly firm would face changes in the composition of the local demand, a tax cut would ease the prices but would still give local monopoly firms incentives to impose the mark-up. A rise in the minimum wage is a fallacy that, empirically, results in the rise of the unemployment and further labor market rigidity that hinders the growth of real productivity, decreases job growth and does not stimulate the real increase in purchasing power parity since higher prices, charged by firms to cover-up the loss from minimum wage, discourage the increase in purchasing power that is not linked to real productivity growth.

"Inflation has replaced unemployment as the most pressing short-term problem facing the oil-rich Gulf economies, which are reaping the benefits of record oil revenues but do not have the tools available to cap rising prices, the International Monetary Fund warned on Monday. Creating jobs for the region’s growing youth population continued to be the main longer-term challenge for Middle Eastern oil exporters, said Mohsin Khan, the IMF’s regional director, but rising prices, already a concern in Qatar and the United Arab Emirates, had now extended across the Gulf Co-operation Council members to traditionally low-inflation countries such as Saudi Arabia, where inflation is approaching 10 per cent... The IMF predicts the Arab Gulf states’ consumer price index will average 7.1 per cent this year, up from 6.1 per cent in 2007 – while the broader Middle East and north Africa region will reach 10.4 per cent this year. With many regional economies pegged to the dollar, central banks lack any monetary policy tools to tackle inflation, leaving fiscal spending, rent caps and price subsidies as the only policy tools available to policymakers. In November last year, for example, rumours of a revaluation in the UAE sparked speculative inflows of $45bn (€29bn, £23bn) in one month, almost a third of the UAE’s gross domestic product... The Middle East and central Asia, which has been largely insulated from global economic uncertainty, was set to continue its strong performance, with oil-exporting countries seeing growth pick up to 6.25 per cent, the IMF said in its biannual regional economic outlook report. The region’s oil and gas exports will amount to $940bn this year, almost $200bn more than last year, as an almost fivefold increase in the price of oil fills the GCC’s coffers. The IMF estimates that the GCC’s combined GDP will reach more than $1,000bn this year, up from $805bn in 2007. The oil exporter’s growing external current account surplus, which is expected to grow to $1,400bn for 2004-2008, signals a continuing ability to invest abroad, while coping with increasing imports and investment into their domestic economies. The GCC’s current account surplus is expected to rise to $332bn from $227bn in 2007, with the UAE’s surplus rising 58 per cent and Qatar’s almost doubling. Official reserves of oil exporters had reached $800bn by the end of 2007. Foreign direct investment into the region reached $80bn in 2007, four times as high as 2002, 55 per cent of which flowed into Egypt, Saudi Arabia and the UAE."

Sunday, May 11, 2008

Aleh Tsvynski and Sergei Guriev wrote a brief article on Russia's state of the economy and political stability. Here's a slice of the article:

"The other major barrier to growth is corruption. In another World Bank-EBRD survey, 40% of firms in Russia reported making frequent unofficial payments, and roughly the same percentage indicated that corruption is a serious problem in doing business. Unlike in other emerging markets, corruption has not declined with economic growth; it remains as high as in countries with one-quarter the per capita income of Russia."

Monday, May 05, 2008

Financial Times reports that Russia's outgoing president Mr. Putin has signed an act which defined 42 sectors of the economy in which state control of the economy is expanded and foreign investment roughly restricted. Under new law, foreign-owned companies will have to seek government permission in case they want to stake more than 25 percent of the company share in the sectors where free investment and ownership participation is staunchly restricted.